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Perfect Competition

Economics for Today by Irvin Tucker, 6th edition©2009 South-Western College Publishing

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What will I learn in this chapter?

This chapter discusses how competitive markets determine prices, output, and profits

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What economic puzzles will I learn to solve?

• Why is the demand curve horizontal for a firm in a perfectly competitive market?

• Why would a firm stay in business while losing money?

• In the short run, can alligator farms earn an economic profit?

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Who was Adam Smith?The father of modern economics who wrote The Wealth of Nations, published in 1776

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What did Adam Smith say about

competitive forces?They are like an “invisible hand” that leads people who pursue their own interests to serve the interests of society

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What ismarket structure?

A classification system for the key traits of a market, including the number of firms, the similarity of the products they sell, and the ease of entry and exit

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What isperfect competition?1. many small firms2. homogeneous product3. very easy entry and exit4. price taker

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What is meant by a large number of firms?A large number of sellers condition is met when each firm is so small relative to the total market that no single firm can influence the market price

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What doeshomogeneous mean?Goods that cannot be distinguished from one another; for example, one potato cannot be distinguished from another potato

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What conclusion can we make?

If a product is homogeneous, buyers are indifferent as to which seller’s product they buy

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What does easy entry mean?

Perfect competition requires that resources be completely mobile to freely enter a market

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What is a price taker?A seller that has no control over the price of the product

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What determines price?

Supply and Demand

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5 10 15 20 25 30 35 40 45

D

S

Market Supply and DemandP

Q

$80

$60

$40

$20

$100

$120

$130$140

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What determines the individual firm’s demand curve?A horizontal line at the market price

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$80

$60

$40

$20

5 10 15 20

$100

$120$130$140

25 30 35 40 45

DIndividual firm demand

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Why is this horizontal line the firm’s

demand curve?If the firm charges more than this price, it will not sell anything, and it has no incentive to charge less than this price

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Why does the firm have no incentive to charge less than the

market price?It can sell everything it brings to market at the market price

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What does the perfectly competitive

firm control?The only thing it controls is how many units it produces

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How many units should this firm produce?

The number of units whereby it will maximize its profits, or at least minimize its losses

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What are the two methods to

determine how many units to produce?

• TR and TC• MR and MC

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Using the total revenue - total cost

method, where should a firm produce?

Where the distance between TR and TC is the greatest

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$400

$100

1 2 4

$300

$200

5

$500

3

Quantity of Output

TRMaximize Profit TC

P

Q

Loss

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$100

-$50

1 2 4

$50

0

5

$150

3

TRMaximize Profit O

utputP

Q

Profit

Loss

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What ismarginal revenue?

MR = TR / 1 output

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What ismarginal cost?

MC = TC / 1 output

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Using the marginal revenue and marginal cost method, where

should a firm produce?

MR = MC

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Why should a firm continue to produce as long as MR > MC?As long as MR is > than

MC, money is being made on that last unit

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Why will a firm not produce that unit where MR < MC?

At the unit of output where MR < MC, money is

being lost on that last unit

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Why does P = AR in perfect competition?Each additional unit sold is adding the market price to TR and TR divided by P = AR

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Why does P = MR in perfect competition?

Because each unit sells for the same price, therefore each unit sold adds the price to total revenue

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What conclusion can we make?

Price equals marginal revenue equals average revenue equals the firm’s short run demand curve

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Why is the firm’s demand curve horizontal

at the market price?

Because the firm can sell all it produces at the market price

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$40

$30

$20

$10

$50

$60

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$80

1 2 3 4 5 6 7 8 9

ATC

AVC

MCP = MR = AR

Profit

MR=MC

Pri

ce &

Co

st p

er u

nit

D

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$40

$30

$20

$10

$50

$60$70 ATC

AVC

MC

1 2 3 4 5 6 7 8 9

P=MR=ARLoss

Pri

ce &

Co

st p

er u

nit MR=MC

P

Q

D

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$40

$30

$20

$10

1 2 3 4

$50

$60$70

5 6 7 8 9

ATC

AVC

MC

P=MR=AR

Shutdown Point

MR=MC

P

Q

Loss

Pri

ce &

Co

st p

er u

nit

D

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Price (MR) is below minimum average

variable cost

Firm will shut down

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What is the perfectly competitive firm’s short-

run supply curve?The firm’s marginal cost curve above the minimum point on its average variable cost curve

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$40

$30

$20

$10

1 2 3 4

$50

$60$70

5 6 7 8 9

ATC

AVC

MC

MR3

Firm’s Short-Run Supply CurveP

Q

MR2

MR1

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What is the industry’s supply curve?

The summation of the individual firm’s MC curves that lie above their minimum AVC points

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$100

25

$80

$60

$40

$20

5 10 15 20

$120

$130

30 35 40 45

S = MC

Industry EquilibriumP

QD

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What is a normal profit?

The minimum profit necessary to keep a firm in operation

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In the long-run, what happens when

economic profits are made?

When firms make more than a normal profit, firms enter the industry, as supply increases, a downward pressure is put on prices

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In the long-run, what happens when

losses are made? When firms make less than a normal profit, firms leave the industry, as supply decreases, an upward pressure is put on prices

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In the long-run, where is equilibrium?

At the market price that enables firms to make a normal profit

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What exists at long-run perfectly competitive

equilibrium?

P = MR = SRMC = SRATC = LRAC

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$40

$30

$20

$10

1 2 3 4

$50

$60$70

5 6 7 8 9

SATC

LRAC

SRMC

MR

Equilibrium

Long-Run Competitive EquilibriumP

Q

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END